Inflation scares most people because the cost of everything goes up. However, inflation has advantages for real estate investors, whether it is your primary residence or investment property. This doesn’t mean that a real estate investment will help lower the cost of gasoline and groceries today, but it can build wealth in the long run. And… today offers a unique short-term window of opportunity for real estate investments.
As we all know, inflation decreases our ability to pay for goods and services when everything becomes more expensive. The basic concept is that when wages remain stable, but goods become more expensive, we can afford to buy less. One of the main drivers of inflation is the base “supply and demand” curve. As demand increases, prices also increase if there is no excess supply. Right now the demand is high because the interest rates are low making it cheaper for people to buy whatever they wanted. This is on top of the stimulus money that has been pumped into the economy to stimulate demand. And all of this is magnified by supply chain bottlenecks that have limited supply. High demand with limited supply is the perfect recipe for inflation.
The Federal Reserve’s most useful tool for controlling inflation is raising interest rates. This is the key to the unique window of opportunity that real estate currently has in this time of inflation.
Specific to real estate, inflation will lead to both higher mortgage rates and higher real estate values. Even if the pace of construction accelerates, new construction (supply) will be more expensive due to inflation. All of this can seem like bad news for both buying a primary residence and expanding an investment portfolio. And it probably will be once interest rates are higher. However, inflation is the borrower’s best friend and the debtor’s worst enemy. Therefore, a short-term window of opportunity exists as interest rates remain low but inflation is high.
Inflation will drive up property values, but today’s low interest rates will turn into cheap money as long-term debt is devalued due to future inflation.
Inflation will accelerate the rise in house prices, but the decline in the loan-to-value ratio of mortgage debt is a natural haircut. This happens because the equity in the property increases while your fixed rate mortgage payments stay the same. This is a natural occurrence with most mortgages, and it becomes overkill in a good way when interest rates are low along with high inflation. An example of a natural event is a $ 100,000 home purchased 10 years ago with a 30-year mortgage and a corresponding monthly payment of $ 470. Today that house is probably worth $ 360,000, but the payments will stay the same for another 20 years. In comparison, someone who pays $ 360,000 for a house today will have a mortgage payment of $ 1,650. All other things being equal, inflation put $ 1,180 more in yesterday’s buyer’s pocket each month compared to today’s buyer (or $ 14,160 each year). An amount of money that will continue to increase for the next 20 years until the mortgage is fully paid off.
However, all other things being equal, tomorrow’s mortgage rates should remain as low as they are today. Freezing low interest rates today (before they go up) will amplify this higher rate of return than inflation. It’s even better…
Borrowing money is using other people’s money to build wealth. A mortgage is other people’s money. When you put in just 15% to buy a property, you get a return not only on that 15%, but also on the remaining 85% due to appreciation. It is not known exactly what the appreciation and inflation rates will be, but historically they are close to 5% for appreciation and 2% for inflation. The difference between these numbers is essential for building wealth with other people’s money.
For example, if you put $ 50,000 on a $ 330,000 house, the 20-year appreciation will give it a value of about $ 876,000. If you subtract the loss in value due to inflation, that $ 330,000 home will be worth about $ 471,000 in today’s dollars. Your net gain will be $ 141,000 in 20 years. This is for a primary owner. For investors with a rental home, the wealth multiplier becomes much more important. Investors will gain the appreciated value along with 20 years of cash flow to pay off the $ 330,000 mortgage, and the rent increases will offset the effect of inflation. Essentially, an investor can expect $ 50,000 to get the full $ 876,000 over 20 years.
Today’s low interest rates will further amplify the down payment multiplier. Real estate is one of the few places where you can lock in a 30-year interest rate. Next month (or next year) the interest rate will be higher to compensate lenders for the rate of inflation. A higher interest rate means higher monthly payments, which will reduce your total earning over the next 20 years. You will gain all the appreciation but less of the inflation multiplier.
The way you maximize the inflationary advantage today is to set yourself a low mortgage rate for the next 30 years before interest rates rise.
Many people see building wealth as an addition to their savings account or 401k retirement account. But these are very sensitive to inflation and are slow to grow. Two factors have the greatest effect on this slow growth. First, none of these accounts increase in value due to appreciation. So this whole growth segment is wiped out in relation to real estate.
Then the banks either pay no more interest on savings accounts than they are lending money for, or they will go bankrupt. Regardless of the rate of inflation, you probably won’t earn more than 0.06% on savings before inflation. When inflation is included, you will lose money overall.
With a 401k, it’s reasonable to expect an annual return of 6% to 7%. This will earn you a cumulative rate of return of between 3.5% and 4.5% against a historical inflation rate of 2.5%. But there is a kick to that. It is only on the money that you have in the investment. With real estate, you just need to make a small down payment to earn 100% of the profits. This means that 85% of real estate income comes from other people’s money. For example, a $ 50,000 investment in a 7% 401k would grow to $ 193,000 in 20 years. Using other people’s money to invest the same $ 50,000 in a $ 330,000 house, you can expect that $ 50,000 to grow to $ 471,000 (or $ 876,000) in 20 years.
Ultimately, high inflation and appreciation rates are good for homeowners. But today’s limited window of opportunity is to lock in a low mortgage before inflation drives higher interest rates.
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Additionally, our weekly Ask Brian column welcomes questions from readers of all levels of experience with residential real estate. Please email your questions, inquiries, or story ideas to [email protected]
Author Biography: Brian Kline has been investing in real estate for over 35 years and has been writing about real estate investing for 12 years. He also draws on more than 30 years of business experience, including 12 years as a director at Boeing Aircraft Company. Brian currently lives in Lake Cushman, Washington. A vacation destination, close to a national and the Pacific Ocean.